The Maximum Drawdown as a Risk Measure: The Role of Real Estate in the Optimal Portfolio Revisited

Abstract

We investigate the role of real estate in a mixed-asset portfolio when the maximum drawdown (hereafter MaxDD), rather than the standard deviation, is used as the measure of risk. We argue that the MaxDD concept is one of the most natural measures of risk, and that such a framework can help reconcile the optimal allocations to real estate and the effective allocations by institutional investors. The emp irical analysis is conducted from the perspective of Swiss pension funds who are faced with legal constraints on the weights that can be allocated to the various asset categories and pertains to the period 1979-2002. We show that most portfolios optimized in Return/MaxDD space, rather than in Return/Standard Deviation space, yield a much lower MaxDD, while only a slightly higher standard deviation (for the same level of return). The reduction in MaxDD is highest for portfolios situated half- way on the efficient frontier, typically close to those held by pension funds. Also, the reported weights for real estate are much more in line with the actual weights to real estate by institutional investors.